Landlords as Speculators

Adam Ozimek writes,

I wonder what housing investment skeptics [sic] Robert Shiller thinks of people who make their livings as landlords. How does this irrational, money losing market exist? After all, if you can’t make a profit by buying a home and renting it to yourself, how is a landlord supposed to?

Pointer from Tyler Cowen.

It is useful to think of owning a house as going into business as a landlord, with you and your family as tenants. I read Ozimek as encouraging us to think along such lines, which makes sense to me. Some further thoughts:

1. As your own landlord, you do not pay income taxes on the rent from your tenants. By the same token, you do not get to deduct as many expenses from your income.

2. As your own landlord, you might have an exorbitant amount of your wealth tied up in your rental property. You can choose less leverage and more diversification by investing instead in the stock market. Ozimek makes it sound like it’s a good thing that you can invest so heavily in housing with so little money down, but leverage multiplies losses as well as gains.

3. Mortgage lenders/investors tend to make a profit, and they are on the opposite side of the transaction as the home buyer. It is unlikely that being on one side is always better than being on the other.

4. My guess is that the landlords who make a profit are smart/lucky speculators. That is, they buy low and sell high. Just buying a random property at a random time and renting it out is less likely to be profitable.

5. As a household, you choose when to buy and sell based on many considerations other than timing the market. A landlord makes the decision solely based on trying to time the market. In the terminology of financial economics, the landlord is a “news trader” and the home buyer is a “noise trader.” On average, news traders tend to profit at the expense of noise traders.

The bottom line is that, yes, you should think like a landlord when you decide about buying a home. And a successful landlord is one with skill and/or luck at choosing when to buy and when to sell. Robert Shiller has a lot of evidence for mean reversion in the ratio of price-to-rent in the housing market. But he does not make his living as a housing speculator. Landlords do.

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20 Responses to Landlords as Speculators

  1. Slocum says:

    1. As your own landlord, you do not pay income taxes on the rent from your tenants. By the same token, you do not get to deduct as many expenses from your income.

    But you can deduct both property taxes and mortgage interest, which are the two largest expenses. In many states, a homeowner pays a lower homestead property tax rate. And, of course, homeowners no longer pay any capital gains taxes when selling a primary residence at a profit. All of this adds up to a significant financial advantage for homeowners vs landlords.

    3. Mortgage lenders/investors tend to make a profit, and they are on the opposite side of the transaction as the home buyer. It is unlikely that being on one side is always better than being on the other.

    But lenders and borrowers aren’t involved in a zero-sum game, are they? Don’t lenders simply provide home-buyers an essential service needed to claim the financial advantages of home ownership?

    4. My guess is that the landlords who make a profit are smart/lucky speculators.

    Even those operating multi-unit buildings?

  2. static says:

    Improvements are often differently valued by renters/owners. Spending a lot of money to improve a property as a business leaseholder generally requires a longer term lease than is typically on offer for residential properties. I see a lot of this where one reason is so difficult to succeed as a restaurant (for example) is that you spend a lot of money to improve a leased property (and build a location based business), but if you are successful the landlord can raise the rent when the lease is up for renewal to capture more of the profits of the location you improved.

    Homeowners often put in immovable improvements (say a swimming pool) that cost quite a bit of money, but do not add a similar value to the market price of the home. Renters are often constrained in terms of upgrades to even things like large appliances. This measure of control over their environment is often what drives people to own, even if it has a cost.

    One way I think about proposed changes to the tax code (in terms of deductibility of mortgage interest and local property taxes) and other policy relevant to home ownership is: at what point does it switch to being more financially advantageous to hold ownership to your home in a business entity instead of as an individual?

    The other thing I have been keeping an eye on is REITs in the single family home sector, such as Colony Starwood (NYSE:SFR). Renting and keeping money in one these REITs would seem to offer exposure to the same asset class, with the REIT using debt to get some of the leverage, potentially augmented by buying them on the margin if you really think that is important. With all of the investments to choose from, would people buy $100k of SFR (maybe on margin?) and rent instead of making a down payment? The reality is a lot of people are horrible at managing money and having a very illiquid investment is the only way they are going to be able to not spend the money.

  3. baconbacon says:

    Alarm bells are ringing.

    “First, owner occupied houses pay a significant annual dividend in the form of free rent. According to Zillow, the average price to rent ratio in the U.S. is around 11, meaning that around 1/11th of the value of a house is saved each year in rent. If you stay in a house for 11 years, you save the equivalent of the price of the house in rent.”

    Yikes. Price to rent is pretty much meaningless, it is cost to rent ratio that matters for a landlord (and all home buyers). Using price to rent ignores property taxes, interest costs, and repairs. Over a 30 year mortgage interest payments (at 4%)will add another 75% onto the price of the home, typical property taxes another 50%+, and repairs another 50% (depending on age and condition). You don’t pay off a house in anything close to 11 years worth of rent savings, starting out with this number and not correcting it is grossly misleading.

    Viewing home ownership as a ‘investment’ is just flat out wrong. Housing is consumption, not an investment.

    Being a landlord is a job, you ‘profit’ roughly in the same way any employee does. The amount of time and effort you put into maintaining a property and selecting tenants will to a large extent determine your salary. You will be exposed to some noise from an increase or decrease in demand in your area which allows for speculation as well.

    • baconbacon says:

      Most people would see this if he had written about cars instead of houses. You are going to buy a car (most people) anyway, why not think of buying a car like leasing it to yourself. Then you just take the cost of the lease as the “income” for your car. After all taxi drivers make money, don’t they?

    • Noah Yetter says:

      When you buy a house you are purchasing a good that yields a stream of utility over time. That’s investment, not consumption, in the economic (not finance) senses of those terms.

  4. BC says:

    (1) and (4) are related. Owner-occupiers have a tax advantage, built into the price of homes, over landlords. A successful landlord needs to have some sort of skill that allows him to overcome the tax disadvantage. Think of tax-free municipal bonds. The pre-tax yields are lower than comparable taxable bonds such that they really make sense only for those in high tax brackets.

    Another factor is that an owner-occupier has a guaranteed tenant, himself, also a tenant that he can trust. If a landlord knew that his property would never sit unoccupied and he would never have a problem tenant, then his likelihood of profitability would go up. Similarly, we usually think that buying a home to live in is a good idea only if one plans to live there for a long period. The folkwisdom against buying a home that one will live in for only a short period is a recognition that having a reliable, guaranteed tenant is a valuable factor in owning property.

  5. Various says:

    3 more things. As an owner occupant, you don’t have vacancy expense and repairs are usually less because your incentives as renter are perfectly aligmed with the owner. Third party renters can sometimes be a little rough on a property, and occasionally you can get a really wild tenant. Finally in certain high cost coastal areas, owner occupants avoid the very substantial costs of rent control

  6. William Brennan says:

    You hear all the time that housing is the key to building wealth. I wonder if there isn’t something deeply behavioral going on here — homeownership as a form of forced savings. People who otherwise find it difficult to save and invest in financial instruments (stocks, bonds, etc.) somehow can commit to “savings” through their mortgage. Get into a house, make the payments, wait 30 years, voila, you have wealth. Not because of tax advantages, or leverage — but because the mortgage was in effect a simple, steady way to save. And if it worked once, why not try it again as a landlord?

    • baconbacon says:

      When down payments were 20% (or more) of the total costs the only people who bought were ones who either bought a small house relative to their income or were savers already. Both correlate with sensible financial decision making.

  7. Regarding point 2, owner-occupied houses do have the diversification problem, but there is a control premium that an owner captures, just as you would pay more to buy 51% of a firm than you would for 49%.

    Regarding points 3-5, this is simply an equity vs. debt comparison, similar to bondholders vs. shareholders. Just as with stocks, the owner captures a higher return over time, on average. Clearly now this is the case. The owner gets the yield from rent after expenses plus capital gains over time (which in most markets on average basically is the inflation rate). With mortgage rates under 4%, there is a huge premium for ownership. Since we have regulated the middle class out of the mortgage market, collapsing demand in low tier markets, most households who have incomes or credit scores that prevent them from qualifying for mortgages would actually lower their cost by buying the homes they are renting, fully leveraged, even before factoring in nominal capital gains they would get.

    The main consideration, just as with stocks, is holding period. The longer your holding period, the more likely you would benefit from ownership. Although, with housing, since it is not diversified, returns can be persistently high or low, and valuations tend to be less noisy than with equities, so the holding period has more to do with amortizing transaction costs and less to do with volatile valuations.

    You don’t buy bonds for capital gains. You buy them for yields. Yields for homeowners are very high now. It is not helpful to think about homeownership with capital gains as the core focus.

    This is one of the many corrosive effects of the broken housing markets in NYC, Boston, LA, and SF/SV. In those cities, capital gains have become a much more important factor because political obstacles to the allocation of capital into new residential housing has caused market prices to be wholly unmoored from replacement cost in those cities. In those cities, buying a house is like buying a taxi medallion. It is not so much a claim on shelter as it is a claim on political exclusion. And, this has infected our entire national psyche, so that incoherent debates about home values don’t seem so incoherent, because there are important parts of the market where fundamentals, such as cost, have ceased to regulate markets.

    • Slocum says:

      “In those cities, buying a house is like buying a taxi medallion. It is not so much a claim on shelter as it is a claim on political exclusion.”

      +1. Great analogy.

    • baconbacon says:

      “With mortgage rates under 4%, there is a huge premium for ownership.”

      Ball park numbers here for a $200,000 house around where I live

      Property taxes~ $6,000/yr
      Insurance ~$1,200
      Interest per year over 30 years at 4% (0% down) ~$4,000
      Repairs* ~ $4,000
      If you expect to earn 5% per year in the market over 30 years you are sacrificing another $5,000 a year.

      You are looking at 1700-1800 a month in excess costs over renting, which is also the range of what a $200,000 house would rent for in this area. Owner implied rent above costs is small to tiny, and in many places and times negative.

      *newer houses have lower repair bills but tend to sell for a premium so that same $200,000 buys you less new house

      • SeanV says:

        Right but rents will go up each year but your mortgage won’t.

        • baconbacon says:

          Taxes, insurance and repairs can all go up, opportunity cost can go up as well. The only part that is literally locked in is your interest rate (which is substantial), but buying also comes with other costs (lower mobility, costs for both moving in and out).

          In short viewing a home purchase as an investment is a poor decision. It is a consumption good with almost all of the value being in the owners option to personalize it as you want.

      • You’re double counting. You are counting $4,000 from a fully leveraged mortgage plus 5% in market returns. Market returns on what?

        Your other expenses seem reasonable, and they add up to about $15,000 in costs (minus the interest rate deduction). Rent at $1,700/month would be about $20,000 per year. So, the owner has a $5,000 gain plus inflationary capital gains on the house, which is basically what I’m saying. I’m not sure what the disagreement is.

        • baconbacon says:

          I’m not double counting, a fully leveraged mortgage would be 8k in interest year 1, it only drops when you build up equity, but that equity build up comes at the cost of not having that money in other markets. So, using a very lazy average of 100k in debt and 100k in equity you have an average interest payment of 4k and an average opportunity cost of 5k.

  8. Andrew' says:

    After reading this, I’m going to raise the rent.

  9. Lord says:

    His point is you can’t choose less leverage and invest more in stocks. Less leverage just means less invested. Leverage is double edged but housing can be safer though not totally safe. While it can be speculative over the short term, it is not entirely so due to the dividends it pays, and is much less so over the long term if investing in a growth area. Interest rates are largely uniform nationally but growth varies widely by area. Growth does become incorporated into the price and can be speculative, but more predictable and slowly changing than equities. Normally both owner and lender profit, the former being equity and the latter debt. Structures depreciate but land appreciates, so yes, it is an investment in growth areas, not so much in non growing areas where it is at best a store of value, and a losing proposition in a declining area.

  10. jack pq says:

    Ozimek is being uncharitable to Shiller. Landlords can make money from the asset dividend (rent) even if the long run capital gain (house or building appreciation net of repairs and investments) is zero as Shiller claims. The landlord’s profit is due to the imperfections of the housing market relative to, say, the stock market.

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